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**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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**x****                       ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarterly period ended September 30, 2008**

 

**OR**

 

**o****                          ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For thetransition period from                 ****to                 **

 

**Commission File Number 0-20191**

 

**INTRUSIONINC.**

(Exactname of small business issuer as specified in its charter)

 

| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Suite 200, Richardson, Texas75081**

(Addressof principal executive offices)

(ZipCode)

** **

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Check whether the Registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days:

 

Yes x   No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large accelerated filer o                      | Accelerated  filer  o         |
|------------------------------------------------|------------------------------------|
| Non-accelerated filer  o                  | Smaller  reporting company  x |
| (Do not check if a smaller  reporting company) |

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act):  Yes o No x

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on October 31,2008 was 11,638,405.

 

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I –  FINANCIAL INFORMATION**                                                                                     |       | 3      |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------|
|                                                                                                                              |       |   |
| Item 1.  Financial Statements                                                                                                     |       | 3      |
|                                                                                                                              |       |   |
| Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2008 and  December 31, 2007                        |       | 3      |
|                                                                                                                              |       |   |
| Unaudited  Condensed Consolidated Statements of Operations for the three and nine months  ended September 30, 2008  and 2007 | ** ** | 4      |
|                                                                                                                              |       |   |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the nine months ended  September 30, 2008 and 2007            |       | 5      |
|                                                                                                                              |       |   |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                                   |       | 6      |
|                                                                                                                              |       |   |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                               |       | 9      |
|                                                                                                                              |       |   |
| Item 4T. Controls and Procedures                                                                                                  |       | 14     |
|                                                                                                                              |       |   |
| **PART II  – OTHER INFORMATION**                                                                                        |       | 14     |
|                                                                                                                              |       |   |
| Item  1. Legal Proceedings                                                                                                        |       | 14     |
|                                                                                                                              |       |   |
| Item  1A. Risk Factors                                                                                                            |       | 14     |
|                                                                                                                              |       |   |
| Item 4. Defaults Upon Senior Securities                                                                                           |       | 22     |
|                                                                                                                              |       |   |
| Item 6.  Exhibits                                                                                                                 |       | 23     |
|                                                                                                                              |       |   |
| Signature Page                                                                                                                    |       | 24     |

 

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**PART I – FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                              | ** ** | **September ****30,  2008** | ** ** | **December ****31,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                              |       |                             |       |                            |       |
| Current Assets:                                                                                                         |       |                             |       |                            |       |
| Cash and cash equivalents                                                                                               |       | $                                | 96         |                            | $          | 362 |   |
| Accounts receivable, less allowance for  doubtful accounts of $40 in 2008 and 2007                                      |       | 761                              |       | 110                             |       |
| Inventories, net                                                                                                        |       | 61                               |       | 146                             |       |
| Prepaid expenses                                                                                                        |       | 32                               |       | 75                              |       |
| Total current  assets                                                                                                   |       | 950                              |       | 693                             |       |
| Property and equipment, net                                                                                             |       | 168                              |       | 144                             |       |
| Other assets                                                                                                            |       | 39                               |       | 39                              |       |
| TOTAL ASSETS                                                                                                            |       | $                                | 1,157      |                            | $          | 876 |   |
|                                                                                                                    |       |                             |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                         |       |                             |       |                            |       |
|                                                                                                                    |       |                             |       |                            |       |
| Current Liabilities:                                                                                                    |       |                             |       |                            |       |
| Accounts payable and accrued expenses                                                                                   |       | $                                | 747        |                            | $          | 688 |   |
| Line of credit                                                                                                          |       | 130                              |       | 100                             |       |
| Loans payable to officer                                                                                                |       | 1,180                            |       | —                          |       |
| Deferred revenue                                                                                                        |       | 205                              |       | 312                             |       |
| Total current liabilities                                                                                               |       | 2,262                            |       | 1,100                           |       |
|                                                                                                                    |       |                             |       |                            |       |
| Stockholders’ Deficit:                                                                                             |       |                             |       |                            |       |
| Preferred stock, $0.01 par value:  Authorized shares – 5,000                                                       |       |                             |       |                            |       |
| Series 1 shares issued and outstanding  — 260  Liquidation preference of $1,364 as of September 30, 2008 |       | 918                              |       | 918                             |       |
| Series 2 shares issued and outstanding  — 460  Liquidation preference of $1,198 as of September 30, 2008 |       | 724                              |       | 724                             |       |
| Series 3 shares issued and outstanding  — 354  Liquidation preference of $805 as of September 30, 2008   |       | 504                              |       | 504                             |       |
| Common stock, $0.01 par value:                                                                                          |       |                             |       |                            |       |
| Authorized shares — 80,000                                                                                         |       |                             |       |                            |       |
| Issued shares — 11,648                                                                                             |       | 116                              |       | 116                             |       |
| Outstanding shares — 11,638                                                                                        |       |                             |       |                            |       |
| Common stock held in treasury, at cost – 10  shares                                                                |       | (362                             | )          | (362                            | )          |
| Additional paid-in capital                                                                                              |       | 55,463                           |       | 55,527                          |       |
| Accumulated deficit                                                                                                     |       | (58,289                          | )          | (57,472                         | )          |
| Accumulated other comprehensive loss                                                                                    |       | (179                             | )          | (179                            | )          |
| Total stockholders’ deficit                                                                                        |       | (1,105                           | )          | (224                            | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                        |       | $                                | 1,157      |                            | $          | 876 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Inthousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
| Net product revenue                                                        |       | $                                | 1,078      |                            | $          | 749 |   | $ | 2,509 |   | $ | 2,476 |   |
| Net customer support and maintenance  revenue                              |       | 137                              |       | 170                             |       | 452 |   | 538 |   |
| Total revenue                                                              |       | 1,215                            |       | 919                             |       | 2,961 |   | 3,014 |   |
| Cost of product revenue                                                    |       | 367                              |       | 355                             |       | 975 |   | 1,129 |   |
| Cost of customer support and maintenance  revenue                          |       | 6                                |       | 15                              |       | 18 |   | 55 |   |
| Total cost of revenue                                                      |       | 373                              |       | 370                             |       | 993 |   | 1,184 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                               |       | 842                              |       | 549                             |       | 1,968 |   | 1,830 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                                        |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                                                        |       | 349                              |       | 499                             |       | 1,081 |   | 1,518 |   |
| Research and development                                                   |       | 210                              |       | 358                             |       | 920 |   | 1,169 |   |
| General and administrative                                                 |       | 244                              |       | 255                             |       | 739 |   | 730 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating income (loss)                                                    |       | 39                               |       | (563                            | )          | (772 | ) | (1,587 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Other income (expense), net                                                |       | —                           |       | —                          |       | — |   | 1 |   |
| Interest income (expense), net                                             |       | (22                              | )          | 1                               |       | (45 | ) | 2 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Income (loss) before income tax provision                                  |       | 17                               |       | (562                            | )          | (817 | ) | (1,584 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Income tax provision                                                       |       | —                           |       | —                          |       | — |   | — |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                                                          |       | $                                | 17         |                            | $          | (562 | ) | $ | (817 | ) | $ | (1,584 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Preferred stock dividends accrued                                          |       | (41                              | )          | (44                             | )          | (121 | ) | (130 | ) |
| Net loss attributable to common  stockholders                              |       | $                                | (24        | )                               | $          | (606 | ) | $ | (938 | ) | $ | (1,714 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Net loss per share attributable to common  stockholders, basic and diluted |       | $                                | (0.00      | )                               | $          | (0.06 | ) | $ | (0.08 | ) | $ | (0.18 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted             |       | 11,638                           |       | 10,397                          |       | 11,638 |   | 9,387 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Inthousands)

 
| ** **                                                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,  2008**    | ** ** | **September 30,   2007** | ** ** |
| Operating Activities:                                                        |       |                            |       |   |   |
| Net loss                                                                     |       | $                               | (817       | ) | $ | (1,584 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                |       | 33                              |       | 45 |   |
| Provision for doubtful accounts                                              |       | —                          |       | (14 | ) |
| Stock-based compensation                                                     |       | 55                              |       | 93 |   |
| Changes in operating assets and  liabilities:                                |       |                            |       |   |   |
| Accounts receivable                                                          |       | (651                            | )          | 451 |   |
| Inventories                                                                  |       | 52                              |       | (19 | ) |
| Prepaid expenses and other assets                                            |       | 43                              |       | 117 |   |
| Accounts payable and accrued expenses                                        |       | (61                             | )          | (305 | ) |
| Deferred revenue                                                             |       | (107                            | )          | (16 | ) |
| Net cash used in operating activities                                        |       | (1,453                          | )          | (1,232 | ) |
| Investing Activities:                                                        |       |                            |       |   |   |
| Purchases of property and equipment                                          |       | (23                             | )          | (39 | ) |
| Financing Activities:                                                        |       |                            |       |   |   |
| Net activity under line of credit                                            |       | 30                              |       | (100 | ) |
| Borrowings from officer                                                      |       | 1,180                           |       | — |   |
| Dividends paid on preferred stock                                            |       | —                          |       | (115 | ) |
| Proceeds from the issuance of common stock                                   |       | —                          |       | 1,500 |   |
| Net cash provided by financing activities                                    |       | 1,210                           |       | 1,285 |   |
|                                                                         |       |                            |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | (266                            | )          | 14 |   |
| Cash and cash equivalents at beginning of  period                            |       | 362                             |       | 933 |   |
| Cash and cash equivalents at end of period                                   |       | $                               | 96         |   | $ | 947 |   |
|                                                                         |       |                            |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                   |       |                            |       |   |   |
|                                                                         |       |                            |       |   |   |
| Preferred stock dividends accrued                                            |       | $                               | 121        |   | $ | 130 |   |
| Inventory transferred to property and  equipment                             |       | $                               | 33         |   | $ | — |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.               Description of Business

 

We develop, market and support a family of entity identification,regulated information compliance, data privacy protection and network intrusionprevention/detection products.  Ourproduct families include:  TraceCopTMfor identity discovery and disclosure, Compliance CommanderTM for regulated information and dataprivacy protection, and Intrusion SecureNetTM for network intrusion prevention and detection.  Our products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

 

We market and distribute our products through a direct sales force toend-users, distributors and system integrators, managed service providers andvalue-added resellers. Our end-user customers include banks, credit unions,other financial institutions, U.S. federal government entities, foreigngovernment entities and local government entities, high technology, e-commerceand telecommunication companies, hospitals and other healthcare providers andacademic institutions.  Essentially, ourend-users can be defined as ‘any end-users requiring network security solutionsfor protecting their mission critical data’.

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our EssentialCommunications division and our local area networking assets. On June 1,2000, we changed our name from ODS Networks, Inc. to Intrusion.com, Inc.,and our ticker symbol from ODSI to INTZ to reflect our focus on intrusionprevention and detection solutions, along with information compliance and dataprivacy protection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices are located at 1101 East Arapaho Road, Suite 200,Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM andTraceCopTM are trademarks of Intrusion Inc.

 

As of September 30, 2008, we had cash, cash equivalents andinvestments of approximately $96,000, down from approximately $0.4 million asof December 31, 2007.  Although we generatednet income of $17,000 in the third quarter of 2008, operating cash outflows maycontinue through the fourth quarter of 2008 and possibly later into the fiscalyear 2009.  The sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources. As of September 30, 2008, we had cash and cash equivalents of$96,000, $196,000 in funding available under our line of credit at SiliconValley Bank and $1.0 million funding available from a written commitmentto invest up to $1.5 million from G. Ward Paxton, the Company’s Chairman,President and Chief Executive Officer.  Basedon projections for continued growth in revenue and net income in the comingquarters, a commitment from the Company’s CEO to advance the Company up to anadditional $1.0 million in funding should it be necessary and $2.5 million lineof credit with borrowings available of $196,000 at September 30, 2008, webelieve that our available credit line and available cash resources willprovide sufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months.  We expect to fund ouroperations through Company profits, our line of credit, and possibly additionalinvestments of private equity and debt, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming quarters, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

2.               Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Item10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financial statements.  The December 31, 2007 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that the disclosuresare adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three and nine month periods ending September 30,2008 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in our annual report on Form 10-KSB for theyear ended December 31, 2007, filed with the commission on March 28,2008.

 

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3.               Inventories (In thousands)

 
| ** **              | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **              | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Inventories consist of: |       |                         |       |                        |       |
|                    |       |                         |       |                        |       |
| Finished goods          |       | $                            | 48         |                        | $          | 123 |   |
| Work in progress        |       | 8                            |       | 8                           |       |
| Demonstration systems   |       | 5                            |       | 15                          |       |
| Net inventory           |       | $                            | 61         |                        | $          | 146 |   |

 

4.               LoansPayable to Officer

 

On January 30, 2008, we enteredinto a revolving promissory note to borrow up to $700,000 from G. WardPaxton, the Company’s Chairman, President and Chief Executive Officer.   Underthe terms of the note, the Company may borrow, repay and reborrow on the loanas needed up to an outstanding principal amount of $700,000 at any date.  All outstanding principal and accrued butunpaid interest were originally due on December 31, 2008 but were extendedon November 7, 2008 to mature on December 31, 2009.  As of September 30, 2008 we hadborrowings of $700,000 from the note with accrued interest payable of$26,500.  On March 20, 2008, wereceived a written commitment from our Chief Executive Officer to investup to an additional $1,500,000 in the Company until March 2009, shouldsuch funding be required by the Company. The maturity date of funds borrowed under this commitment was extendedon November 7, 2008 to March 2010. Amounts the Company borrows under the note and the commitmentaccrue interest at a floating rate per annum equal to the announced prime rateof Silicon Valley Bank (“SVB”) plus 1% and are unsecured.  As of September 30, 2008 we hadborrowings under the commitment of $500,000 with accrued interest payable of$12,300.  Interest expense related to the loan and thecommitment from the Chief Executive Officer totaled $18,000 and $39,000,respectively, for the three and nine months ended September 30, 2008.

 

5.               Lineof Credit

 

On March 29, 2006,we entered into a Loan and Security Agreement (the “Prior Agreement”) with SVBto establish a $1.0 million line of credit (the “Prior Line of Credit”) withSVB.  On June 30, 2008, we enteredinto an Amended and Restated Loan and Security Agreement (the “Loan Agreement”)with SVB to, among other things, replace the Prior Line of Credit with a new$2.5 million line of credit (the “Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  Borrowings under the Line ofCredit are based on advances (each, an “Advance”) against certain of ouraccounts receivable that are approved by SVB (“Eligible Accounts”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of (a) the greater of the prime rate or 5.25%,plus (b) 1.5% or 2.0%, depending on certain qualifying financial factorsspecified in the Loan Agreement.  Financecharges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthly collateralhandling fee of 0.25% or 0.5% of all outstanding Advances, depending on certainqualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  On June 29,2009, the Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsdue under the Loan Agreement and related documents.  We have $130,000 outstanding under thiscredit line as of September 30, 2008 and had borrowings available of$196,000 based on our borrowing base calculation.

 

6.               Accounting for Stock-Based Compensation

 

The Company recognized$26,000 and $49,000, respectively, stock-based compensation expense for thethree month periods ended September 30, 2008 and 2007.

 

Valuation Assumptions

 

The fair values of employee and director option awards were estimatedat the date of grant using a Black-Scholes option-pricing model with thefollowing assumptions:

 

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| ** **                             | ** ** | **For Three Months  Ended  September 30, 2008** | ** ** | **For Three Months  Ended  September 30, 2007** | ** ** | **For Nine Months  Ended  September 30, 2008** | ** ** | **For Nine Months  Ended  September 30,  2007** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
|                                   |       |                                                                |       |                                                                |       |                                                               |       |                                                           |       |
| Weighted average grant date fair value |       | —                                                              |       | $                                                                   | 0.30       |                                                               | $          | 0.17                                                           |       | $ | 0.32 |   |
| Weighted average assumptions used:     |       |                                                                |       |                                                                |       |                                                               |       |                                                           |       |
| Expected dividend yield                |       | —                                                              |       | 0.0                                                                 | %          | 0.0                                                                | %          | 0.0                                                            | %          |
| Risk-free interest rate                |       | —                                                              |       | 4.9                                                                 | %          | 2.6                                                                | %          | 4.9                                                            | %          |
| Expected volatility                    |       | —                                                              |       | 103.6                                                               | %          | 107.1                                                              | %          | 105.1                                                          | %          |
| Expected life (in years)               |       | —                                                              |       | 5.0                                                                 |       | 5.0                                                                |       | 4.9                                                            |       |
|                                        |            |                                                                     |            |                                                                     |            |                                                                    |            |                                                                |            |  |  |  |

 

Expected volatility is based on historical volatility and in part onimplied volatility.  The expected termconsiders the contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward. Options granted to non-employees are valued using the fair market valueon each measurement date of the option.

 

7.               Net Income (Loss) Per Share

 

Basic net income (loss) pershare is computed by dividing net loss attributable to common stockholders forthe period by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and dilutive common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the diluted loss per share calculation for theperiods ended September 30, 2008 and 2007 are 4,223,951 and 4,131,756,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three andnine month periods ended September 30, 2008 and 2007, as they areantidilutive.

 

8.               New Accounting Pronouncements

 

In February 2008, FASB Staff Position (“FSP”) FAS No. 157-2, *Effective Date of FASB Statement No. 157*(“FSP 157-2”),was issued. FSP 157-2 defers the effective date of SFAS 157-2 tofiscal years beginning after December 15, 2008, and interim periods withinthose fiscal years, for all nonfinancial assets and liabilities, except thosethat are recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). Examples of items within the scope ofFSP 157-2 are nonfinancial assets and nonfinancial liabilities initiallymeasured at fair value in a business combination (but not measured at fairvalue in subsequent periods), and long-lived assets, such as property, plantand equipment and intangible assets measured at fair value for an impairmentassessment under SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*.

 

The partial adoption of SFAS 157-2 on January 1, 2008 withrespect to financial assets and financial liabilities recognized or disclosedat fair value in the financial statements on a recurring basis is not expectedto have a material impact on our consolidated financial statements. We are inthe process of analyzing the potential impact of SFAS 157-2 relating toour planned December 31, 2008 adoption of the remainder of the standard.

 

In December 2007, FASB issued SFAS No. 160, *Non-Controlling Interests in Consolidated Financial Statements anamendment of ARB No. 51* (“SFAS 160”). SFAS 160establishes new standards for the accounting for and reporting ofnon-controlling interests (formerly minority interests) and for the loss ofcontrol of partially owned and consolidated subsidiaries. SFAS 160 doesnot change the criteria for consolidating a partially owned entity.SFAS 160 is effective for fiscal years beginning after December 15,2008. We do not expect the adoption of SFAS 160 will have a material impacton our consolidated financial statements.

 

Also in December 2007, FASB issued SFAS No. 141(revised2007) (“SFAS 141R”), a revision of SFAS 141, *BusinessCombinations*.  SFAS 141Restablishes requirements for the recognition and measurement of acquired assets,liabilities, goodwill, and non-controlling interests. SFAS 141R alsoprovides disclosure requirements related to business combinations.SFAS 141R is effective for fiscal years beginning after December 15,2008. SFAS 141R will be applied prospectively to business combinationswith an acquisition date on or after the effective date.

 

9.               Commitments and Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

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10.         Dividends Payable

 

During the quarterended September 30, 2008, we accrued $16,000 in dividends to the holdersof our 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  As of September 30,2008, we have $147,000 in accrued and unpaid dividends included in accountspayable and accrued expenses.  Delawarelaw provides that we may only pay dividends out of our capital surplus or, ifno surplus is available, out of our net profits for the fiscal year thedividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years and as of the nine months ended September 30, 2008, did nothave sufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of September 30, 2008, the aggregate redemption price we wouldowe would be approximately $2.0 million.

 

11.   Subsequent Event

 

OnNovember 7, 2008, the maturity date of funds borrowed under the commitmentfrom our Chief Executive Officer was extended from March 2009 toMarch 2010.

 

Item 2.             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward LookingStatements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934 (The “Exchange Act”). Such forward-looking statements are generallyaccompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,”“could,” “anticipate,” “may” or other words that convey uncertainty of futureevents or outcomes.  These statementsrelate to future events or to our future financial performance, and involveknown and unknown risks, uncertainties and other factors that may cause ouractual results, levels of activity, performance, or achievements to bematerially different from any future results, levels of activity, performance orachievements expressed or implied by these forward-looking statements. Factorsthat may cause actual results to differ materially from current expectations,which we describe in more detail elsewhere in this Quarterly Report on Form 10-Qunder the heading “Factors That May Affect Future Results of Operations,”and in our 2007 Annual Report on Form 10-KSB in “Item 1 – Description ofBusiness” include, but are not limited to:

 

·                  insufficient cash to operate ourbusiness and inability to meet our liquidity requirements;

 

·                  loss of revenues due to the failureof our newer products to achieve market acceptance;

 

·                  our need to continue current revenueslevels in order to sustain profitability;

 

·                  concentration of our revenues fromU.S. government entities and the possibility of loss of one of these customersand the unique risks associated with government customers;

 

·                  our dependence on sales made throughindirect channels;

 

·                  the challenge of selling our productsinternationally;

 

·                  our dependence on equity or debtfinancing provided primarily by our Chief Executive Officer in order to meetour cash flow requirements;

 

·                  the effect that payment of accrueddividends on our preferred stock has on our cash resources and the substantialdilution upon the conversion or redemption of our preferred stock and exerciseof outstanding warrants;

 

·                  the impact of conversion of preferredstock or exercise of warrants on the price of our common stock;

 

·                  the ability of our preferredstockholders and lenders to hinder additional financing; and

 

·                  the influence that our management andlarger stockholders have over actions taken by the company.

 

If one or more of theseor other risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. These forward-looking statements and other statements made elsewherein this report are made in reliance on the Private Securities Litigation ReformAct of 1995.  Any forward-lookingstatement you read in this Quarterly Report on Form 10-Q or our AnnualReport on Form 10-KSB reflects our current views with respect to futureevents and is subject to these and other risks, uncertainties and assumptionsrelating to our operations, results of operations, growth strategy andliquidity. We assume no obligation to publicly update or revise theseforward-looking statements for any reason, or to update the 

 

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reasons actual resultscould differ materially from those anticipated in these forward-lookingstatements, even if new information becomes available in the future.  The section below entitled “Factors That May AffectFuture Results of Operations” sets forth and incorporates by reference certainfactors that could cause actual future results of the Company to differmaterially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourunaudited condensed consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

 

*Revenue Recognition*

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs and sales returns at the time of shipmentbased on our experience. Revenue from maintenance contracts is deferred andrecognized over the contractual period the services are performed, generallyone year.  There is a risk that technicalissues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followingcriteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical salesinformation on our product offerings.  Wedefer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.

 

We generally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation, are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. Ourreceivables are uncollaterized and we expect to continue this policy in thefuture.  If the financial condition ofour customers were to deteriorate, resulting in an impairment of their abilityto make payments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

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*Inventory*

 

We write down our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.  Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
|                                              |       | **Three Months Ended** |       | **Nine Months Ended**  |       |
|---------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **September ****30,  2008** | ** ** | **September ****30,  2007** | ** ** | **September ****30,  2008** | ** ** | **September ****30,  2007** | ** ** |
| Net product revenue                               |       | 88.7                             | %          | 81.5                             | %          | 84.7 | % | 82.2 | % |
| Net customer support and maintenance  revenue     |       | 11.3                             |       | 18.5                             |       | 15.3 |   | 17.8 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0                            |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                           |       | 30.2                             |       | 38.6                             |       | 32.9 |   | 37.5 |   |
| Cost of customer support and maintenance  revenue |       | 0.5                              |       | 1.6                              |       | 0.6 |   | 1.8 |   |
| Total cost of revenue                             |       | 30.7                             |       | 40.3                             |       | 33.5 |   | 39.3 |   |
| Gross profit                                      |       | 69.3                             |       | 59.7                             |       | 66.5 |   | 60.7 |   |
| Operating expenses:                               |       |                             |       |                             |       |   |   |   |   |
| Sales and marketing                               |       | 28.7                             |       | 54.4                             |       | 36.5 |   | 50.4 |   |
| Research and development                          |       | 17.3                             |       | 39.0                             |       | 31.1 |   | 38.8 |   |
| General and administrative                        |       | 20.0                             |       | 27.7                             |       | 25.0 |   | 24.2 |   |
|                                              |       |                             |       |                             |       |   |   |   |   |
| Operating income (loss)                           |       | 3.2                              |       | (61.3                            | )          | (26.1 | ) | (52.7 | ) |
|                                              |       |                             |       |                             |       |   |   |   |   |
| Interest income (expense), net                    |       | (1.9                             | )          | (61.2                            | )          | (1.5 | ) | (52.6 | ) |
| Income (loss) before income tax provision         |       | 1.4                              |       | (61.2                            | )          | (27.6 | ) | (52.6 | ) |
|                                              |       |                             |       |                             |       |   |   |   |   |
| Income tax provision                              |       | —                           |       | —                           |       | — |   | — |   |
|                                              |       |                             |       |                             |       |   |   |   |   |
| Net income (loss)                                 |       | 1.4                              | %          | (61.2                            | )%         | (27.6 | )% | (52.6 | )% |
| Preferred stock dividends accrued                 |       | (3.7                             | )          | (4.8                             | )          | (4.2 | ) | (4.3 | ) |
|                                              |       |                             |       |                             |       |   |   |   |   |
| Net loss attributable to common  stockholders     |       | (2.3                             | )%         | (66.0                            | )%         | (31.8 | )% | (56.9 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **September ****30,  2008** | ** ** | **September ****30,  2007** | ** ** | **September ****30,  2008** | ** ** | **September ****30,  2007** | ** ** |
|                |       |                             |       |                             |       |   |   |   |   |
| Domestic revenues   |       | 97.1                             | %          | 95.0                             | %          | 96.1 | % | 92.8 | % |
| Export revenues to: |       |                             |       |                             |       |   |   |   |   |
| Europe              |       | 2.6                              |       | 4.1                              |       | 3.4 |   | 6.3 |   |
| Canada              |       | 0.0                              |       | 0.1                              |       | 0.0 |   | 0.1 |   |
| Asia                |       | 0.2                              |       | 0.6                              |       | 0.3 |   | 0.7 |   |
| Latin America       |       | 0.1                              |       | 0.2                              |       | 0.2 |   | 0.1 |   |
|                |       |                             |       |                             |       |   |   |   |   |
| Net revenues        |       | 100.0                            | %          | 100.0                            | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenues for the quarter and ninemonths ended September 30, 2008 were $1.2 million and $3.0 million,respectively, compared to $0.9 million and $3.0 million for the same periods in2007.  Product revenues increased $0.3million for the quarter ended September 30,2008, and increased $33 thousand for the nine months ended September 30,2008 compared to the same periods in 2007. Increased product revenues are due to an increase in sales of ourTraceCop product line.  Customer supportand maintenance revenue decreased $32 thousand and $86 thousand for the quarterand nine months ended September 30, 2008 compared to the same periods in2007.  This decrease was due to thecurrent sales mix with a high concentration of government sales not requiring amaintenance contract.

 

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** **

**Concentrationof Revenues**.  Revenues from sales to various U.S.government entities totaled $1.1 million, or 91.2% of revenues, for the quarterended September 30, 2008 compared to $0.7 million, or 75.4% of revenues,for the same period in 2007.  Revenuesfrom sales to various U.S. government entities totaled $2.5 million, or 84% ofrevenues, for the nine months ended September 30, 2008 compared to $2.3million, or 75.3% of revenues, for the same period in 2007.    Although we expect our concentration ofrevenues to vary among customers in future periods depending upon the timing ofcertain sales, we anticipate that sales to government customers will continueto account for a significant portion of our revenues in future periods.  Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including, without limitation, potentialdisruption to appropriation and spending patterns and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.  Although we do not believethat any of our revenues with government customers are subject torenegotiation, a large number of cancelled or renegotiated government orderscould have a material adverse effect on our financial results.  Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangements withgovernment entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**GrossProfit**.  Gross profit was $0.8 million or 69.3%of net revenues for the quarter ended September 30, 2008, compared to $0.5million or 59.7% of net revenues for the quarter ended September 30,2007.  Gross profit was $2.0 million or66.5% of net revenues for the nine months ended September 30, 2008compared to $1.8 million or 60.7% of net revenues for the nine months ended September 30,2007.   Gross profit on product revenuesfor the quarter and nine months ended September 30, trended from 52.6% and55.4%, respectively, in 2007 to 66.0% and 61.2%, respectively, in 2008 mainlydue to an increase in net revenues and/or decreases in fixed costs.  Gross profit on customer support andmaintenance revenues for the quarter and nine months ended September 30,trended from 91.2% and 89.8% respectively, in 2007 to 95.5% and 96.1%,respectively, in 2008.  Gross profit as a percentage of net revenuesis impacted by several factors, including shifts in product mix, changes inchannels of distribution, revenue volume, pricing strategies, and fluctuationsin revenues of integrated third-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreasedto $0.3 million for the quarter ended September 30, 2008, compared to $0.5million for the quarter ended September 30, 2007. Sales and marketingexpenses decreased to $1.1 million for the nine months ended September 30,2008, compared to $1.5 million for the nine months ended September 30,2007 primarily due to a planned reduction in sales and marketing relatedexpenses.  Sales and marketing expensesmay vary in the future.  However, webelieve that these costs will remain relatively constant through the end of2008, although expenses may be increased relative to increases in revenue.

 

**Researchand Development**.  Research and development expensesdecreased to $0.2 million for the quarter ended September 30, 2008compared to $0.4 million for the quarter ended September 30, 2007.Research and development expenses decreased to $0.9 million for the nine monthsended September 30, 2008, compared to $1.2 million for the nine monthsended September 30, 2007.  Research and development costs areexpensed in the period incurred. Research and development expenses decreased in the three and nine monthsended September 30, 2008, compared to the same periods in 2007 primarilydue to shifts from research and development expenses to cost of sales inrelation to engineering contract jobs. Research and development expenses may vary in the future; however, webelieve that these costs will remain relatively constant through the end of2008, although expenses may be increased relative to increases in revenue.

 

 

**General andAdministrative**.  General and administrative expensesdecreased at $0.2 million for the quarter ended September 30, 2008compared to $0.3 million for the quarter ended September 30, 2007.  General and administrative expenses remainedat $0.7 million for the nine months ended September 30, 2008, compared to$0.7 million for the nine months ended September 30, 2007.  Itis expected that general and administrative expenses will remain relativelyconstant throughout the remainder of 2008, although expenses may be increasedrelative to increases in revenue.

 

**Interest**.  Netinterest expense increased to $22 thousand interest expense for the quarterended September 30, 2008 compared to $1 thousand interest income for thesame period in 2007.  Net interestexpense increased to $45 thousand for the nine months ended September 30,2008 compared to $ 2 thousand of interest income for the same period in2007.  The increase in interest expensewas primarily due to an increase in interest expenses related to borrowingsfrom a loan payable to an officer and the line of credit.  Net interest expense may vary in the futurebased on our cash flow, operating income and capital expenditures.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at September 30, 2008 is approximately $ 96 thousand of cash andcash equivalents.  At September 30,2008, we had a working capital deficiency of $1.3 million compared to a surplusof $0.4 million at September 30, 2007.

 

Cash used inoperations for the nine months ended September 30, 2008 was $1.5 million,primarily due to a net loss of $817 thousand, an increase in accountsreceivable of $651 thousand, a decrease in accounts payable and accruedexpenses of $61 thousand, and decreases in deferred revenue of $107thousand.  This cash decrease waspartially offset by depreciation expense of $33 thousand, 

 

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stock-basedcompensation expense of $55 thousand, a decrease in inventories of $52thousand, and a decrease in prepaid expenses and other assets of $43thousand.  Cash used in operations forthe nine months ended September 30, 2007 was $1.2 million, primarily dueto a net loss of $1.6 million and the following uses of cash: a $305 thousanddecrease in accounts payable and accrued expenses, a $19 thousand increase ininventories, a $16 thousand reduction in deferred revenue and a $14 thousandreduction in the provision for doubtful accounts.  This was partially offset by the followingsources of cash and non-cash items: a $451 thousand decrease in accountsreceivable, a $117 thousand decrease in prepaid expenses and other assets, $93thousand in stock-based compensation and $45 thousand in depreciationexpense.   Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

There was $23thousand of cash used in investing activities in the nine months ended September 30,2008 compared to $39 thousand of cash used in investing activities in the ninemonths ended September 30, 2007 for net purchases of property andequipment.

 

Cash provided by financingactivities in the nine months ended September 30, 2008 was $1.2 million,primarily consisting of the proceeds from a promissory note and commitment byour Chief Executive Officer, G. Ward Paxton, for $1.2 million with a net increasein the line of credit of $30 thousand compared to cash provided by financingactivities in the nine months ended September 30, 2007 of $1.3 million,primarily consisting of the proceeds from the issuance of common stock of $1.5million, partially offset by payment of dividends on preferred stock of $115thousand and a net reduction in the line of credit of $100 thousand.

 

At September 30,2008, the Company did not have any material commitments for capitalexpenditures.

 

During the nine monthsended September 30, 2008, the Company funded its operations through theuse of cash and cash equivalents, and borrowings of $1.2 million from our CEO,G. Ward Paxton and $0.13 million from our line of credit.

 

On March 29, 2006,we entered into a Loan and Security Agreement (the “Prior Agreement”) with SVBto establish a $1.0 million line of credit (the “Prior Line of Credit”) withSVB.  On June 30, 2008, we enteredinto an Amended and Restated Loan and Security Agreement (the “Loan Agreement”)with SVB to, among other things, replace the Prior Line of Credit with a new$2.5 million line of credit (the “Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  Borrowings under the Line ofCredit are based on advances (each, an “Advance”) against certain of ouraccounts receivable that are approved by SVB (“Eligible Accounts”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of (a) the greater of the prime rate or 5.25%,plus (b) 1.5% or 2.0%, depending on certain qualifying financial factorsspecified in the Loan Agreement.  Financecharges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthlycollateral handling fee of 0.25% or 0.5% of all outstanding Advances, dependingon certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  The LoanAgreement terminates and all outstanding advances, accrued but unpaid financecharges, outstanding collateral handing fees, and other amounts due under theLoan Agreement and related documents.  Wehave $130,000 outstanding under this credit line as of September 30, 2008and had additional borrowings available of $196,000 based on our borrowing basecalculation.

 

Although we generated net income of $17,000 in the third quarter of2008, operating cash outflows may continue through the fourth quarter of 2008and possibly later into the fiscal year 2009. The sufficiency of our cash resources may depend to a certain extent ongeneral economic, financial, competitive or other factors beyond ourcontrol.  In addition, we are obligatedto make payments of accrued dividends on all our outstanding shares ofpreferred stock that will reduce our available cash resources.   As of September 30, 2008, we had cashand cash equivalents of $96,000, $196,000 in funding available under our lineof credit at Silicon Valley Bank and $1.0 million funding available from awritten commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections for continuedgrowth in revenue and net income in the coming quarters, a commitment from theCompany’s CEO to advance the Company up to an additional $1.0 million in fundingshould it be necessary and $2.5 million line of credit with borrowingsavailable of $196,000 at September 30, 2008, we believe that our availablecredit line and available cash resources will provide sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, and possibly additional investments ofprivate equity and debt, which, if we are able to obtain, will have the effectof diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the upcoming quarters, or ifwe are not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

We may explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business.  We are continuingto identify and prioritize additional security technologies, which we may wishto develop, either 

 

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internally or through thelicensing, or acquisition of products from third parties.  While we may engage from time to time indiscussions with respect to potential acquisitions, there can be no assurancesthat any such acquisitions will be made or that we will be able to successfullyintegrate any acquired business.  In orderto finance such acquisitions and working capital it may be necessary for us toraise additional funds through public or private financings.  Any equity or debt financings, if availableat all, may be on terms, which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders.

 

Item 4T.     CONTROLSAND PROCEDURES

 

Wemaintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) and15d-15(e) under the Exchange Act, that are designed to ensure that informationrequired to be disclosed by us in reports we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures,management recognized that disclosure controls and procedures, no matter howwell conceived and operated, can provide only reasonable assurance of achievingthe desired control objectives, and we necessarily are required to apply ourjudgment in evaluating the cost-benefit relationship of possible disclosurecontrols and procedures.

 

Ourmanagement, including our principal executive officer and principal financialofficer, evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of September 30, 2008 and concludedthat the disclosure controls and procedures were effective.

 

Therehave not been any changes in our internal control over financial reporting thatoccurred during the quarter ended September 30, 2008 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II – OTHER INFORMATION**

 

Item 1.             LEGALPROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

Item 1A.                           RISK FACTORS

 

**Factors That May Affect Future Resultsof Operations**

 

We are providing the following information regarding changes that haveoccurred to previously disclosed risk factors from our Annual Report on Form 10-KSBfor the year ended December 31, 2007. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading “FactorsThat May Affect Future Results of Operations” in our Form 10-KSB forthe year ended December 31, 2007. The risks described in our Quarterly Reports on Form 10-Q are notthe only risks facing our Company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.

 

***Ourcash, cash equivalents, and investments decreased from $0.4 million at December 31,2007 to $ 96 thousand at September30, 2008. If net cash outflows continue, we may not have sufficient cash tooperate our business and may not be able to maintain certain liquidityrequirements.  Additional debt and equityofferings to fund future operations may not be available and, if available, maysignificantly dilute the value of our currently outstanding common stock.***

 

As of September 30, 2008, we had cash, cash equivalents andinvestments of approximately $96 thousand, down from approximately $0.4 millionas of December 31, 2007.  Althoughwe generated net income of $17,000 in the third quarter of 2008, operating cashoutflows may continue through the fourth quarter of 2008 and possibly laterinto the fiscal year 2009.  Thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  As of September 30, 2008, we had cash and cash equivalents of$96,000, $196,000 in funding available under our line of credit at SiliconValley Bank and $1.0 million funding available from a written commitmentto invest up to $1.5 million from G. Ward Paxton, the Company’s Chairman,President and Chief Executive Officer.  Basedon projections for continued growth in revenue and net income in the comingquarters, a commitment from the Company’s CEO to advance the Company up to anadditional $1.0 million in funding should it be necessary and $2.5 million lineof credit with borrowings available of $196,000 at September 30, 2008, webelieve that our available credit line and available cash resources willprovide sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect to fund ouroperations through Company profits, our line of credit, and possibly additionalinvestments of private equity and debt, which, if we are able to obtain, will 

 

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havethe effect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming quarters, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***Ifour newer products do not achieve market acceptance, our revenues may decline.***

 

We have transitioned oursales strategy focus from SecureNet to TraceCop and Compliance Commander.  During this transition, sales of our newerproducts have only recently offset the losses in sales associated with ourolder products.  We can provide noassurances that sales of our newer products will continue to offset the lossesin sales of older products or generate sufficient revenues to sustain ourbusiness.

 

Our new network securityproducts, regulated information compliance systems and entity identificationproducts have only been in the market place for a limited period of time andmay have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

 

We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and increase sales of our newerproducts, we must introduce complementary security products, incorporate newtechnologies into our existing product lines and design, develop andsuccessfully commercialize higher performance products in a timely manner.  We cannot assure you that we will be able tooffer new or complementary products that gain market acceptance quickly enoughto avoid decreased revenues during current or future product introductions ortransitions.

 

***Wehave historically incurred losses and have an accumulated deficit of $58.3million as of September 30, 2008. To achieve continued profitability, we must continue to generate revenuelevels equal to or greater than revenues we were able to achieve in the thirdquarter ended September 30, 2008.***

 

We incurred modestoperating income for the quarter ended September 30, 2008, but haveincurred operating losses in previous years. For the year ended December 31, 2007, we incurred a net loss of$2.4 million and had an accumulated deficit of approximately $57.5 million asof December 31, 2007. ** **We need to generate and sustainrevenues levels equal to or greater than revenues in the third quarter ended September 30,2008 if we are to achieve continued profitability.  If we are unable to achieve these revenuelevels, losses may be suffered in the near term and possibly longer.  To the extent that revenues decline or do notgrow at anticipated rates, increases in operating expenses precede or are notsubsequently followed by commensurate increases in revenues or we are unable toadjust operating expense levels accordingly, your investment could bejeopardized.

 

***A large percentage of our revenues are received from U.S.government entities, and the loss of one of these customers could reduce ourrevenues and materially harm our business and prospects.***

 

A large percentage of ourrevenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended September 30,2008, sales to U.S. government entities collectively accounted for 91.2% of ourrevenues.  For the years ended December 31,2005, 2006****and 2007, sales to U.S.government entities collectively accounted for 70.7%, 73.6% and 73.2% of ourtotal net revenues, respectively. The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering. We cannot assure you that U.S. government entities will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***Government customers involve unique risks, which couldadversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns,delays in approving a federal budget and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding, qualificationrequirements, delays or changes in funding, budgetary constraints, politicalagendas, extensive specification development and price negotiations andmilestone requirements.  Each governmententity also maintains its own rules and regulations with which we mustcomply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

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***Weare highly dependent on sales made through indirect channels, the loss of whichwould materially adversely affect our operations.***

 

We derived 35.2% ofrevenue in the third quarter of 2008 through indirect channels of mainlygovernment resellers.  For the yearsended December 31, 2005, 2006 and 2007, we derived 36.2%, 17.3% and 19.2%of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We must expand our sales through these indirect channels in order toincrease our revenues.  We cannot assureyou that our products will gain market acceptance in these indirect saleschannels or that sales through these indirect sales channels will increase ourrevenues.  Further, many of ourcompetitors are also trying to sell their products through these indirect saleschannels, which could result in lower prices and reduced profit margins forsales of our products.

 

***International sales comprise a portion of our overallrevenues.  Our ability to sell ourproducts internationally is subject to certain risks, which could harm ourbusiness.***

 

Foreign sales in thethird quarter of 2008 were 2.9% of revenue. Revenues from foreign customers for the fiscal years ended December 31,2005, 2006 and 2007 accounted for approximately 10.7%, 9.4% and 9.2%,respectively, of our revenue.  We expectsales to foreign customers to continue to represent a significant portion ofour revenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

 

·                  political,social and economic instability;

 

·                  traderestrictions;

 

·                  increases induty rates and other potentially adverse tax consequences;

 

·                  exposure todifferent legal standards, particularly with respect to the protection ofintellectual property;

 

·                  burdens ofcomplying with a variety of foreign laws;

 

·                  unexpectedchanges in regulatory requirements;

 

·                  import andexport license requirements and restrictions of the United States and eachother country where we operate;

 

·                  fluctuations incurrency exchange rates; and

 

·                  changes in localpurchasing practices, including seasonal fluctuations in demand.

 

Any interruptions ordeclines in our international sales would result in a significant adverseimpact on our results of operations and business.

 

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

 

On March 25,2004, we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1Preferred Stock”) and warrants to acquire 556,619 shares of our commonstock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  As of October 31, 2008,there were 259,696 shares of the Series 1 Preferred Stock outstanding,representing approximately 413,003 shares of common stock upon conversion.

 

On March 28,2005, we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of October 31,2008, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a $1,230,843 private placementpursuant to which we issued 564,607 shares of our Series 3 5% PreferredStock (the “Series 3 Preferred Stock”) and warrants to acquire 282,306shares of our common stock.  Thepreferred shares may be converted into 564,607 shares of common stock at aninitial conversion price of $2.18 per share, and the warrants may be exercisedat a price of $0.40 per share during the five-year period commencing on June 2,2006.  As of October 31, 2008, therewere 354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

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*** ***

***Wehave been unable to pay scheduled dividends on shares of our preferred stock,and the continued failure to make such payments has resulted in late penaltypayments and could potentially result in additional consequences, some of themmaterial.***

 

During the quarterended September 30, 2008, we accrued $16,000 in dividends to the holdersof our 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of thenine months ended September 30, 2008, did not have sufficient capitalsurplus, defined as the amount by which our net assets exceed our statedcapital, based on par value of our outstanding shares as provided by Delawarelaw.  We cannot assure you that our netassets will exceed our stated capital or that we will have net profits in orderto pay these dividends in the future. These dividends continue to accrue on all our outstanding shares ofpreferred stock, regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of November 13, 2008, the aggregate redemption price we would owewould be approximately $2.0 million.

 

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

 

On October 31,2008, we had 11,638,405 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have14,389,318 shares of common stock outstanding, approximately a 25.0% increasein the number of shares of our common stock outstanding.

 

Further, the occurrenceof certain events could entitle holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amountsto the holders, (ii) incurred accrued but unpaid dividends on October 31,2008 of $89,000, (iii) a volume weighted average price of $0.28, which wasthe ten-day volume weighted average closing price of our common stock on October 31,2008, and (iv) our 11,638,405 shares of common stock outstanding on October 31,2008, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 12,321,000 shares of our common stock.  This would represent an increase ofapproximately 106% in the number of shares of our common stock as of October 31,2008.

 

In addition, managementmay issue additional shares of common stock or securities exercisable orconvertible into shares of common stock in order to finance our continuingoperations.  Any future issuances of suchsecurities would have additional dilutive effects on the existing holders ofour Common Stock.

 

***Theconversion of preferred stock or exercise of warrants we issued in the privateplacements may cause the price of our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto Rule 144 of the Securities and Exchange Commission.  As of October 31, 2008, 740,304 sharesof our 5% Preferred Stock had converted into 1,177,327 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may freely convert their sharesof preferred stock and exercise their warrants and sell the underlying sharesof common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of October 31, 2008,605,200 shares of Series 2 Preferred Stock had converted into 605,200shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may freely convert their sharesof Series 3 Preferred Stock and exercise their warrants and sell the underlyingshares of common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of October 31, 2008,210,551 shares of Series 3 Preferred Stock had converted into 210,551shares of common stock.

 

For the four weeks endedon October 31, 2008, the average daily trading volume of our common stockon The OTCBB was 1,043 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants 

 

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and sell a materialamount of their underlying shares of common stock on the open market, theincrease in selling activity could cause a decline in the market price of ourcommon stock.  Furthermore, these sales,or the potential for these sales, could encourage short sales, causingadditional downward pressure on the market price of our common stock.

 

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

 

Under the terms ofour preferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of atleast a majority of the holders of our 5% Preferred Stock, all of the holdersof our Series 2 5% Preferred Stock, and holders of at least 75% of our Series 35% Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of each class of ourPreferred Stock.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Weresemble a developmental stage company and our business strategy may not besuccessful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We haverecently introduced our regulated information compliance systems and entityidentification products, and the market for these products has only begun toemerge.  We can provide no assurancesthat our newly introduced products will ever achieve widespread marketacceptance or that an adequate market for these products will ever emerge.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

·                  the need for ournetwork security products, regulated information compliance systems and entityidentification products to achieve market acceptance and produce a sustainablerevenue stream;

 

·                  our ability tomanage costs and expenses;

 

·                  our dependenceon key personnel;

 

·                  our ability toobtain financing on acceptable terms; and

 

·                  our ability tooffer greater value than our competitors.

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products, regulated information compliance systems and entityidentification products, our business, financial condition and operatingresults would be materially adversely affected.

 

***Our management and larger stockholders exercise significantcontrol over our company and have the ability to approve or take actions thatmay be adverse to your interests.***

 

As of October 31,2008, our executive officers, directors and preferred stockholders beneficiallyown approximately 39% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management group beneficiallyholds.

 

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***We face intense competition from both start-up andestablished companies that may have significant advantages over us and ourproducts.***

 

The market for network securitysolutions is intensely competitive. There are numerous companies competing withus in various segments of the data security markets, and their products mayhave advantages over our products in areas such as conformity to existing andemerging industry standards, interoperability with networking and othersecurity products, management and security capabilities, performance, price,ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Ourprincipal competitors in the network intrusion prevention and detection marketinclude Internet Security Systems, Inc. (IBM), Cisco Systems, Inc.,Symantec, Inc., Juniper Networks, Inc., McAfee Inc., Tipping PointTechnologies, a division of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu (Symantec), Port Authority (Websense),Vericept, Reconnex, Tablus and a small number of start-up companies thatentered the space within the last two years. Our current and potentialcompetitors may have one or more of the following significant advantages overus:

 

·                  greater financial, technical and marketing resources;

 

·                  better name recognition;

 

·                  more comprehensive security solutions;

 

·                  better or more extensive cooperative relationships;and

 

·                  larger customer base.

 

We cannot assure you thatwe will be able to compete successfully with our existing or newcompetitors.  Some of our competitors mayhave, in relation to us, one or more of the following: longer operatinghistories, longer-standing relationships with OEM and end-user customers andgreater customer service, public relations and other resources. As a result,these competitors may be able to more quickly develop or adapt to new oremerging technologies and changes in customer requirements, or devote greaterresources to the development, promotion and sale of their products.Additionally, it is likely that new competitors or alliances among existingcompetitors could emerge and rapidly acquire significant market share.

 

***If we fail to respond to rapid technological changes in thenetwork security industry, we may lose customers or our products may becomeobsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

 

***Our products are highly technical and if they contain undetectederrors, our business could be adversely affected and we might have to defendlawsuits or pay damages in connection with any alleged or actual failure of ourproducts and services.***

 

Our products are highlytechnical and complex, are critical to the operation of many networks and, inthe case of our security products, provide and monitor network security and mayprotect valuable information. Our products have contained and may contain oneor more undetected errors, defects or security vulnerabilities. Some errors inour products may only be discovered after a product has been installed and usedby end customers. Any errors or security vulnerabilities discovered in ourproducts after commercial release could result in loss of revenues or delay inrevenue recognition, loss of customers and increased service and warranty cost,any of which could adversely affect our business and results of operations. Inaddition, we could face claims for product liability, tort or breach ofwarranty. Defending a lawsuit, regardless of its merit, is costly and maydivert management’s attention. In addition, if our business liability insurancecoverage is inadequate or future coverage is unavailable on acceptable terms orat all, our financial condition could be harmed.

 

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***Abreach of network security could harm public perception of our securityproducts, which could cause us to lose revenues.***

 

If an actual or perceivedbreach of network security occurs in the network of a customer of our securityproducts, regardless of whether the breach is attributable to our products, themarket perception of the effectiveness of our products could be harmed. Thiscould cause us to lose current and potential end customers or cause us to losecurrent and potential value-added resellers and distributors. Because thetechniques used by computer hackers to access or sabotage networks changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques.

 

***Ifour products do not interoperate with our customers’ networks, installationswill be delayed or cancelled and could harm our business.***

 

Our products are designedto interface with our customers’ existing networks, each of which havedifferent specifications and utilize multiple protocol standards and productsfrom other vendors. Many of our customers’ networks contain multiplegenerations of products that have been added over time as these networks havegrown and evolved. Our products will be required to interoperate with many orall of the products within these networks as well as future products in orderto meet our customers’ requirements. If we find errors in the existing softwareor defects in the hardware used in our customers’ networks, we may have tomodify our software or hardware to fix or overcome these errors so that ourproducts will interoperate and scale with the existing software and hardware,which could be costly and negatively impact our operating results. In addition,if our products do not interoperate with those of our customers’ networks,demand for our products could be adversely affected, orders for our productscould be cancelled or our products could be returned. This could hurt ouroperating results, damage our reputation and seriously harm our business andprospects.

 

***Whilewe believe that we currently have adequate internal control over financial reporting,we are exposed to risks from recent legislation requiring companies to evaluatethose internal controls.***

 

Section 404 of theSarbanes-Oxley Act of 2002 requires our management to report on theeffectiveness of our internal control over financial reporting. We have anongoing program to perform the system and process evaluation and testingnecessary to comply with these requirements. We have and will continue to incursignificant expenses and devote management resources to Section 404compliance on an ongoing basis. In the event that our chief executive officer,chief financial officer or independent registered public accounting firmdetermine in the future that our internal controls over financial reporting arenot effective as defined under Section 404, investor perceptions may beadversely affected and could cause a decline in the market price of our stock.

 

***Our products can have long sales and implementation cycles,which may result in us incurring substantial expenses before realizing anyassociated revenues.***

 

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Consolidation in the network security industry may limitmarket acceptance of our products.***

 

Several of ourcompetitors have acquired security companies with complementary technologies inthe past.  We expect consolidation in thenetwork security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

***We must adequately protect our intellectual property inorder to prevent loss of valuable proprietary information.***

 

We rely primarily on acombination of copyright, trademark and trade secret laws, confidentialityprocedures and non-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse-engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protectproprietary rights to the same extent as the laws of the United States and maynot provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves

 

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to be inadequate orunenforceable, others may be able to use our proprietary developments withoutcompensation to us, resulting in potential cost advantages to our competitors.

 

***We may incur substantial expenses defending ourselvesagainst claims of infringement.***

 

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems.  Third partiesmay claim that our products infringe on their intellectual property rights.  Any claim, with or without merit, couldconsume our management’s time, result in costly litigation, cause delays insales or implementations of our products or require us to enter into royalty orlicensing agreements. Royalty and licensing agreements, if required andavailable, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

 

***Fluctuations in our quarterly revenues may cause the priceof our common stock to decline.***

 

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond tounexpected decreases in revenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and disproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

 

***Theprice of our common stock has been volatile in the past and may continue to bevolatile in the future due to factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, infiscal year 2007, the market price of our common stock on The OTCBB Market fluctuatedbetween $0.17 and $0.75 per share.  Themarket price of our common stock may fluctuate significantly in response to anumber of factors, many of which are outside our control, including:

 

·                  variations in our quarterly operating results;

 

·                  changes in estimates of our financial performance bysecurities analysts;

 

·                  changes in market valuations of our competitors;

 

·                  announcements by us or our competitors of newproducts, significant contracts, acquisitions, strategic relationships, jointventures or capital commitments;

 

·                  product or design flaws, product recalls or similaroccurrences;

 

·                  additions or departures of key personnel;

 

·                  sales of common stock in the future; and

 

·                  fluctuations in stock market prices and volume, whichcan be particularly common among network security and other high technologycompanies.

 

***Our past reductions in our work force may make it moredifficult for us to attract and retain the personnel necessary to successfullyoperate our business.***

 

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales andmanagerial personnel.  We do not haveemployment agreements with our key technical, sales and senior managementpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

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***Ouracquisition of complementary products or businesses may adversely affect ourfinancial condition.***

 

We have made acquisitionsin the past and, in the future we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***Compliance with export regulations may hinder our sales toforeign customers.***

 

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations.  Any inabilityto obtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisionsof our charter documents and Delaware law may have anti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which restricts certain businesscombinations with interested stockholders and could inhibit a non-negotiatedmerger or other business combination.

 

***Militaryactions may disrupt our business by reducing spending on our products,increasing our costs and affecting our international operations.***

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

·                  reducing or delaying government, military or corporatespending on network security products;

 

·                  increasing the cost and difficulty in obtainingmaterials or shipping products; and

 

·                  affecting our ability to conduct businessinternationally.

 

Should theseevents occur, our business, operating results and financial condition could bematerially and adversely affected.

 

Item 4.                                Defaults Upon Senior Securities

 

During the quarterended September 30, 2008, we accrued $16,000 in dividends to the holdersof our 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of thenine months ended September 30, 2008, did not have sufficient capitalsurplus, defined as the amount by which our net assets exceed our statedcapital, based on par value of our outstanding shares as provided by Delawarelaw.  We cannot assure you that our netassets will exceed our stated capital or that we will have net profits in orderto pay these dividends in the future. These dividends continue to accrue on all our outstanding shares ofpreferred stock, regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required to redeemall shares of Series 2 Preferred Stock and Series 3 Preferred Stockas of November 13, 2008, the aggregate redemption price we would owe wouldbe $2.0 million.

 

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Item 6.                                Exhibits

 

The following Exhibitsare filed with this report form 10-Q:

 

 
| 10.1.  | Letter, dated November 7, 2008, from G. Ward Paxton  to Intrusion Inc.                                                                                                          |
|-------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1        | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                             |
| 31.2        | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                             |
| 32.1        | Certification Pursuant to Rule 13a-14(b) of the  Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **                   | **INTRUSION INC.** |
|------------------------------|--------------------|
|                         |               |
| Date: November 13, 2008 |               | /s/ G. Ward Paxton |
|                         |               | G. Ward Paxton |
|                         |               | Chairman, President & Chief Executive  Officer |
|                         |               | (Principal Executive Officer) |
|                         |               |
|                         |               |
| Date: November 13, 2008 |               | /s/ Michael L. Paxton |
|                         |               | Michael L. Paxton |
|                         |               | Vice President, Chief Financial Officer,  Treasurer & Secretary |
|                         |               | (Principal Financial & Accounting Officer) |

 

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